Latest from TH: "Thanks. Hopefully we’ll get the SCOTUS ruling before the Fourth of July, then we all can begin speculating on what’s likely to happen in the next phase of the Fannie/Freddie saga.
Since no one has asked about the recent paper by Don Layton titled “The FHFA’s Report on Credit Risk Transfer,” with the subtitle “Another Controversial Document Further Erodes Confidence in the Agency,” I thought I’d take this opportunity to volunteer a few brief comments about it.
I had been wondering how Layton might respond to the FHFA piece on CRTs, since he has been such a strong advocate of them. As the subtitle of his paper indicates, he has decided to lump the CRT report in with three other recent regulatory actions–the capital rule, the “living will” regulation, and the January letter agreement requiring Fannie and Freddie to limit the amount of some of the business they do–and make the case that FHFA is biased and a bad regulator, and that as a consequence its CRT report shouldn’t be taken seriously.
I think the capital rule is a disaster, and am no fan of either the restrictions Calabria has put on Fannie and Freddie’s business or its (unnecessary and intensely bureaucratic) living will requirement. But I also think one needs to address the CRT paper on its merits. Layton pointedly does not do this, saying he will “not do a soup-to-nuts analysis of the CRT report.” Instead, he focuses on “four important benefits of CRT either not mentioned or just slightly referenced in passing,” which is the bias he claims the paper exhibits. In his view, these four ignored or downplayed benefits are: (a) systemic risk reduction, (b) taxpayer risk reduction, (c) capital reduction, and (d) market discipline.
Where Layton’s paper falls short, however, is that he doesn’t make the case for how CRTs could have these “four important [theoretical] benefits” if even in a repeat of the loss performance of Fannie and Freddie’s 2007 books of business (their worst by far) they still cost them $20 billion MORE than they return in loss transfers. That neither reduces systemic risk nor protects taxpayers; by weakening the companies (through having them pay out $30 billion and only getting back $10 billion), it does the opposite. And while the CRTs DO reduce the companies’ capital, it’s not in the way Layton intends.
The problem with Fannie and Freddie’s CRTs is that they kick in at too high a level of cumulative loss, they insure against risks that are far too remote, and they can prepay rapidly and thus disappear before they can be called upon–as the ever-to-date experience (admittedly in a highly favorable economic and financial environment) and the performance simulations show. While they may be great in theory, in practice Fannie and Freddie’s CRTs are extremely costly giveaways to Wall Street and the investor community, that increase the companies’ vulnerability to the credit risk they end up retaining."
